Part 2: Principles of Portfolio Construction

Building a portfolio is not just about picking "good" investments; it is about understanding the environment in which those investments live. We follow three core principles to ensure we are taking the right risks at the right price.

1. Risk is Not Just a Number

While the industry uses formulas to calculate "risk-adjusted returns”, we believe these models have a blind spot: valuation. Standard models often mistake low volatility for low risk. However, we view risk through the lens of probability:

  • Priced for Perfection: When markets are booming and volatility is low, valuations are often at extreme highs. In this scenario, the ‘textbook’ says risk is low, but the reality is that all the good news could already be priced in. There is very little room for upside, and any unknown negative event will have an outsized, damaging impact given both fundamental and valuation expectations have to adjust.
  • The Opportunity of Fear: Conversely, during a crisis (like the 2008 GFC), volatility is high and the outlook is dire. Models suggest the risk is extreme. Yet, because prices are so low, the probability of future gains is actually much higher.

As Warren Buffett famously advised, we aim to be "fearful when others are greedy, and greedy when others are fearful." We use qualitative judgment to see past the volatility and understand the true cost of the risk we are taking.

2. Active vs. Passive: Choosing the Right Game

The debate between active management (trying to beat the market) and passive management (tracking the index) is often presented as a binary choice. Our view is more pragmatic: we are indifferent, as long as the odds are in our favor.

It is important to understand, not all markets are created equal:

  • Harder to Win: In market capitalisation indices like the ASX 200, or the S&P 500 the top 10-20 stocks make up a disproportionate part of the index. These companies are so heavily researched that finding a hidden gem is nearly impossible. Beating these indexes consistently is much harder.
  • Easier to Win: In sectors like Australian Small Caps, the index is often cluttered with unprofitable companies or stagnant real estate trusts. A skilled manager can outperform simply by avoiding the ‘junk’ that the index is forced to hold.

We believe in harvesting extra returns from wherever is best. That means we can be more or less active in different sectors. We do not think it matters if your extra returns come from Small Caps, Credit, or Emerging Markets—a dollar of outperformance spends the same regardless of its origin. We prefer to take our active bets in markets where the odds are structurally tilted in our favor.

3. The Fee Budget: Maximizing ‘Bang for Buck’

We treat investment fees as a finite budget that should be spent where it generates the highest return. We call this Transportable Alpha.

If active managers in a certain category (like Global Equities) have a 95% failure rate despite charging high fees, it is statistically unwise to spend your budget there. Instead, we may choose a low-cost ‘passive’ option for that category and "transport" those saved fees toward an area like Credit, where active managers have a much higher success rate and lower costs.

By being clinical about where we pay for skill and where we opt for low-cost efficiency, we ensure that your total portfolio is optimized for a cheaper, more reliable outcome.

This post is part two of a three-part series on portfolio construction. You can read part 1 here.